July 5, 2021

The Pros and Cons of Sustainable Investing

By: Daniel Huizinga

The last year has accelerated societal change in many ways, and the rise of ESG investing is quickly emerging as another way to transform our investing approach.

More investment funds than ever before focus on companies that prioritize “environmental, social, or governance” (ESG) criteria, and money in these funds has more than doubled in the past year while the number of funds overall has quadrupled over the last decade. A broader definition of “sustainably-invested assets” finds more than $30 trillion globally invested as of 2018. Several factors are driving the growth of sustainable investing, including generational changes in opinion, a more widespread focus on sustainability, and an increasing willingness of corporate leaders to use their companies to advocate for positions on social and political issues. 

People should be free to invest their money according to their values – that’s just one benefit of our free market system. But as more evidence begins to emerge about ESG funds, it’s clear that there is still considerable disagreement about what ESG means and how it should be valued. As most major companies now pay lip-service to ESG objectives, it can also be difficult to credibly identify which companies are truly focused on ESG objectives, rather than “greenwashing” (making public statements about ESG that aren’t actually reflected in the company’s strategy or operations). 

One effort to solve this problem has been the rise of ESG-ratings systems, organizations that attempt to score companies on dozens of ESG metrics, including everything from carbon emissions to controversial labor practices to diversity in leadership. Of course, what really drives a company’s final ESG “score” is the weights assigned to each of these variables, which can be somewhat arbitrary. In December 2019, The Economist compared the scores of two leading ESG-rating systems, showing a relatively low correlation between them. (For example, companies that scored high on one rating system were not very likely to score high on the other system – indicating there is still a lot of disagreement on how to properly weight ESG factors.) The “Aggregate Confusion Project” at MIT continues to illustrate this problem and advocate for solutions.

But even assuming we will figure out how to objectively and accurately identify which companies are the most “socially responsible,” there’s no guarantee that they will outperform the overall market. Though some studies show ESG-focused funds recently performed about as well as the market (or even outperformed non-ESG funds), longer-term results aren’t as encouraging. Over a 20-year period, for example, the Vanguard FTSE Social Index Fund had about 1 percentage point lower in annualized returns than the Vanguard Growth Index Fund, a similar fund without an ESG focus. 

Another recent study suggests that ESG funds will be destined to underperform, and any short-term outperformance could only be the result of the sudden growth in investors’ desires for ESG funds (which will eventually settle at a new equilibrium). The study notes that investors are willing to pay a premium for the financials of “green assets” (companies with positive social impact), compared to the same financials of a “brown asset” (a company with potential negative effects on society). In the short term, as more investors pour into ESG funds and increase the premium they are willing to pay, ESG funds may still outperform the market (and reward those who got in early). The Economist suggests we may even be experiencing a “green bubble.” 

However, in the long term, paying a premium means ESG investors will potentially achieve lower financial returns along with the happiness benefit of making a positive impact on the world through their investment strategies. This raises a problem when pension funds are making these decisions on behalf of employees who cannot choose another fund – some people may be happy to risk trading off profits for social impact, but others may prefer maximizing their possible wealth in retirement, regardless of which companies they invest in. 

Regardless, the rise of ESG investing has been great for Wall Street fund managers. “Exchange-traded funds that explicitly focus on socially responsible investments have 43% higher fees than widely popular standard ETFs,” argued a recent Wall Street Journal article. The “ESG” label is an easy way to bring in more investors and higher fees, so some companies are taking advantage of these benefits without needing to create a dramatically different investing strategy. 

Wall Street Journal columnist Jason Zweig highlights one of these examples in the “BlackRock U.S. Carbon Transition Readiness ETF,” a fund that is intended to highlight companies committed to reducing carbon emissions. The methodology of the Carbon Transition Fund’s holdings isn’t exactly rocket science. Its “top five companies, totaling 19.5% of total assets, are Apple Inc., Microsoft Corp., Amazon.com Inc., Facebook Inc. and Google’s parent, Alphabet Inc… [while] a sibling fund, iShares Core S&P 500 ETF, holds the identical top five companies, in slightly different order and at 21.5% of total assets.” So what’s the main difference between the two? The “Carbon Transition Fund” charges 5x the annual fees of the iShares fund. 

As I’ve written before, finding low-cost ways to invest is critical if you want to be prepared for retirement. If you choose to limit your investing decisions to companies you believe are socially-responsible, that’s completely up to you! But before taking any “ESG” marketing at face value, make sure to do your own research, understand which companies you’re investing in, and learn how much extra you’re paying in unnecessary fees.